Month: December 2014

The consensus view is that the overall stock market is being dragged down by the slide in oil prices. This makes sense – logic dictates that falling oil prices have an immediate negative impact in terms of dragging down the prices of oil-related equities, and a longer term positive impact due to an increase in consumer spending.

The immediate negative component will be larger now than in the 1980’s, because the economy has grown more dependent upon oil companies in the wake of the 2007-09 crisis. Oil companies were partially responsible for the recovery America has shown since – it makes sense that anything that imperils the health of these companies would imperil the recovery as well.

Oil price may have overshot to the downside. This is the consensus view anyway – most market participants expect the oil price to overshoot to the downside, as part of a Saudi Arabian scheme to shake out American shale oil drillers. Market participants also expect that oil will rebound within 18 months to previous levels (circa $100) after many of the weaker, more highly leveraged firms have been pushed into bankruptcy.

If the consensus view is correct, the move is to be short oil companies now, long retail and airlines, hold until a bottom in the oil price, then switch to well-capitalized mid-cap oil companies. These latter companies will be able to survive the downturn, and emerge more profitable than ever when the oil price picks back up. The added bonus of holding these companies is that oil majors, like Exxon, would rather acquire than drill for growth in an environment of oil price instability, so by picking the strongest companies, investors could benefit from an acquisition.

The fact that there is so much consensus on this makes me nervous. However, I have no basis for arguing with it. The real question, then, is whether I should join in. With oil prices in the mid $50’s currently, I can answer with a no. The risk of joining the “short oil, long retail and airlines” play is that a trend so advanced may easily correct, so even if I got the trend right, I could be pushed out with a loss by a sharp correction.

Therefore, I have to wait for the next leg of events to begin to participate. In the meantime, I have to formulate a working hypothesis of what is going on.

One thing is apparent, if the market is really falling because of oil, then the market should stop falling when oil bottoms. However, if oil price were to stabilize at current levels and the market were to continue to decline, it could be a sign of something bigger.

I have been expecting a serious correction in equity prices for some time, but I have been repeatedly punished for my bearish views. This could be simply a case of wishful thinking. However, there was a sharp correction earlier this year, that I never found a satisfactory explanation for, other than simply “valuation”.

The fact that market participants are starting to take valuation into consideration is dangerous for the market. In an environment of historically low interest rates, we would expect historically high valuations. If participants are starting to question this process, it could begin to unravel. What makes such an unravelling especially dangerous is the fact that the Fed probably has the data it needs to begin to raise interest rates. Market participants placing more importance on valuation considerations, combined with an increase in interest rates, could create a rapid and deep correction, and possibly a bear market.

The only argument I have against this scenario is that there are strong disinflationary forces in the market: 1) the falling oil price and 2) the strong dollar. These may function to keep inflation below the Fed’s target, allowing it to delay the interest rate hike further and further into the future. The market consensus has been that the rate increase would happen in the early part of 2015, however, latest events should push this at least into the latter half of 2015, if not later.

If this is the case, then the bull market ought to be able to sustain itself, and the indexes will emerge from this dip stronger than ever. In fact, after so many small corrections, we might expect valuations to completely detach from reality. We might see former high flyers in the tech space regain their peaks.

On the other hand, if the market continues to slide after oil stabilizes, then the market may be in for a longer term beating, in which high-flyers are pulled down by the market correction.

One thing is for sure: oil cannot stay in free fall forever. Eventually, it will hit a bottom, and at a current price of $56, I think this will happen sooner rather than later. Then we will have our answer to the above question, and I will have a basis for beginning some speculations.